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Lehman Brothers Plus Five: Have We Learned From Our Mistakes?

Is the US financial system in better shape today than it was five years ago? Harvard Business School finance professors Victoria Ivashina, David Scharfstein, and Arthur Segel see real progress—but also missed opportunities and more challenges.

In September 2008, Lehman Brothers went under—the largest bankruptcy in American history. But that was just the beginning of the story. What followed was the Great Recession, a gargantuan financial crisis that affected the entire world economy. Five years later, we’re wondering if the US financial system is in better shape. Professors Victoria Ivashina, David Scharfstein, and Arthur Segel, all members of the Harvard Business School Finance Unit, examine the current state of affairs.

Victoria Ivashina:

Is the US financial system in better shape today than it was five years ago? The short answer is yes.

The safety of the financial system depends on financial institutions’ risk exposure, their ability to absorb losses, their reliance on short-term wholesale funding, transparency, and understanding the interconnectedness between large financial institutions. In

NEW YORK, NY - SEPTEMBER 16: Tourists pose in front of the iconic Wall Street Bull near the New York Stock Exchange on September 16, 2013 in New York City. Five years after the beginning of the financlial crisis marked by the bankrupcy of Lehman Brothers, Wall Street has more than recovered its losses, although unemployment in the United States remains high. (Image credit: Getty Images via @daylife)

2008, each one of these points was a source of stress for the system’s stability. Today, banks are better capitalized, rely less on short-term wholesale funding, and make available much more detailed information about their portfolios, while the amount of “shadow banking” has shrunk dramatically. In addition, a considerable amount of high-quality research has been done regarding financial stability.

Some of these steps were prompted by regulatory changes—or anticipation of such changes. But perhaps the biggest force in stabilizing the financial system has been greater public scrutiny and market retrenchment from risk-taking activities. However, since market forces were shown to be an unreliable mechanism for ensuring the soundness of the financial system over the long term, there is real pressure for making fundamental changes in the way we deal with the risks embedded in the financial system.

Hence the understandable frustration voiced by many about the slow progress in writing the rules required by the Dodd-Frank Act. That said, we need to be aware not just that 40 percent of rules have been finalized in three years, but that this process involves a delicate balance between not unnecessarily weakening the conditions of credit supply (especially in a slowly recovering economy) and improving the soundness of the financial system. The interaction between regulators and the private sector is a crucial ingredient in getting these rules right, something that is clearly not captured by the hard statistics.

In an environment often eager for simple answers, many reflections surrounding the fifth anniversary of Lehman’s collapse suggest that the financial system is riskier today because it is more concentrated. Indeed, there are fewer banks, and asset concentration among the top 100 banks has increased slightly compared to pre-crisis levels. However, the three largest US banks—JP Morgan, Bank of America and Citigroup—represent about the same fraction of these assets that they did before the crisis.

More important, we must acknowledge that we now understand far better (albeit not perfectly) how these institutions affect one another. This expertise—combined with better institutional transparency and the banks’ new lower—risk practices-leads to a more stable system than the one that existed five years ago. But for the financial system to be safer five years from now, more substantive actions to fend off the accumulation of systemic risk are both expected and needed.

David Scharfstein:

The financial crisis revealed significant problems in our financial system and its regulation. Five years later, although all these problems haven’t been solved, we’ve made some progress. The Dodd-Frank Act, which was passed by Congress in 2010, created a mechanism to deal with many of them, alongside Basel III the most recent iteration in global banking regulations. Important details of both are still being hammered out.

The most progress has probably been made in enhancing the capital positions of large banking institutions. “Systemically significant” banks are now required to hold an extra layer of capital and undergo regular and more extensive stress tests to see if they can withstand a significant economic and financial downturn.

Banks are also being pushed to rely less on short-term debt financing, an attractive source of funding in good times but an accelerant of financial crises when things go bad. And we’re getting closer to adopting a “resolution regime” that could enable regulators to wind down a financial firm without the sort of havoc created by the Lehman failure. None of these reforms is perfect, but they are improvements over where we were five years ago.

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